Sunday, November 15, 2009

The secrets behind John Paulson's success...

The banking and credit crisis of 2008 had few heroes and lots of investing legends who were humbled. Very few of these so called experts saw the crisis coming, and even those who did were unable to act on that belief.

One exception is John Paulson, a hedge fund manager/investor based in New York. He saw a bubble in the housing market in 2006 and created a hedge fund to bet on the bubble bursting; what made his bet unique was that his use of the Credit Default Swap (CDS) market to bet that sub-prime securities would collapse and he was right. Greg Zuckerman, a reporter at the Wall Street Journal, has a short article reviewing Paulson's strategy in the link below.
http://online.wsj.com/article/SB125823321386948789.html?mod=googlenews_wsj

Greg, whose writing I enjoy reading, is probably the world's leading authority on Paulson (other than Paulson himself), since he has spent the last year researching the man and has written a book on his investing acumen. You can get the book, titled "The Greatest Trade Ever" at your local bestseller:
http://www.amazon.com/Greatest-Trade-Behind-Scenes-ebook/dp/B002UBRFFU/ref=sr_1_1?ie=UTF8&s=books&qid=1258333719&sr=8-1

In his Wall Street Journal article, Greg has a collection of lessons that the average investor can learn from Paulson. While I agree with most of them, I do disagree with one point that he makes, i.e., that the bond market is a better predictor of problems than the stock market. The bond market is a better predictor of credit risk and default problems than the equity market, simply because it is far more focused on that risk. Equity investors juggle a lot more balls in the air- growth, risk and cash flows - and they can get distracted, especially about default risk. History suggests, however, that equities have led bonds in predicting economic growth and profitability.

Here is where I agree with Greg. I think equity investors will gain by paying attention to bond markets, just as bond investors will gain by being aware of developments in equity markets. We have compartmentalized investing to the point that investors are often unaware of when these markets become disconnected, which are the danger signals that one market has become mispriced. In the context of valuation, here is where I think this recognition is most useful.

1. Risk Premiums: In my paper on equity risk premiums, I have a section where I compare implied equity risk premiums and default spreads on bonds and not the correlation between the two over time. The periods when they have moved in opposite directions, such as 1996-99 (when equity premiums dropped and default spreads rose) and 2004-2007 (when default spreads dropped while equity risk premiums remained stagnant) were precursors to major market corrections - the dot com bubble in the equity market in 2000 and the sub-prime bubble in the bond market in 2007-08.
2. Distressed companies: When valuing equity in distressed companies, the threat of default constants overhangs the entire valuation. I believe that we can derive valuable information from the corporate bond market that can help up refine and modify the valuation of distressed companies. I describe this process in this paper.

If Paulson's lessons are heeded, we should see more joint work between equity research analysts and bond analysts and a greater willingness to look across markets for investing clues. I am not holding my breath!!!

P.S: For those of you who are conspiracy theorists, John Paulson is not related to former treasury secretary and Goldman CEO, Hank Paulso.

P.S2: A disclosure is in order. John Paulson just gave $ 20 million to the Stern School of Business at NYU, where I teach. Since did not partake in this gift, I think I can still be objective about his investing strategies.

5 comments:

custodes said...

Professor,

Slightly off topic, but have you seen a long term relationship with ERPs and bond spreads in relation to credit ratings. In other words, have you noticed consistency in the credit rating of a firm and the difference between the ERP and the default spread.

Gaurav Mehta said...

The best think i liked about the article is that often it is easy to identify bubbles but difficult to time the bubble burst, the strategy that he used to play the bubble by buying CDS was to me thinking out of the box if not un imaginable. Since even if he was sure that there is a bubble, if he had used shorting as a method to make money on the bubble he would have lost enough money by 2007 to never think of shorting again.

One particlar bubble i can see in the future is Alternative Energy when every one would be trying to run after companies with anything to do with alternative source of energy (even name would do).

As for bond or equity markets being better indicators, i think having seen both the markets pretty closely for the last 3-4 years both markets have the capability of leading and lagging at different points in time depending on the related information.

When the sub prime housing markets started collapsing in May - July 2007, bond markets moved first we could see the problems coming for the equity markets. Bonds were already trading at 90 -85 cents to a dollar which was unheard of prior to this. To think of it this was the only time when bond markets looked like equity markets with super returns in the last one year.

perpetual wonderer said...

@ custodes:

In a perfect world, the fundamentals would result in a downgrade/upgrade of credit ratings for a particular firm. This rating will be factored in, by the market, by increasing/decreasing the ERP for its shares along with a increase/decrease in its bond spreads. So in that sense, a change in the risk premiums would follow after a ratings revision (along with a host of other indicators).

Immortal said...

Thanks Prof for bloggin this article...

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