$1 Billion Tax and an Incredible Investment Story

John Paulson, a large hedge fund manager, owed Federal and state taxes of $1 billion this week. And he owed $500 million a year ago, April 2017.

Incredible. That is so large that the IRS cannot even process it all in one check, as the IRS cannot accept a check for more than $999,999,999. A problem we should all have!

But there is much more to this story, which you should know about.

Paulson’s huge tax liabilities are from $15 billion of profits he and his hedge funds made by betting against subprime mortgages prior to 2008-09.  He was able to defer the payment of those taxes until 2016 and 2017 because of a tax law which no longer exists.

How have Paulson and his firm, Paulson & Co., done since 2008?

This is where the story gets even more interesting than the huge tax payment.

After Paulson’s 2008 success, investors flocked into his funds. By 2011 his hedge fund firm was one of the industry’s largest, managing $38 billion seven years ago, according to the Wall Street Journal.  Today however, Paulson is managing less than $9 billion and most of that is his own money.

Why the huge reversal of fortune?

Paulson’s oldest fund, Partners Fun, has underperformed the S&P 500 every year since 2008.

For 9 straight years, from 2009-2017, his main hedge fund underperformed the S&P 500 and often by incredibly large margins.

Chart Information above is found in WSJ Article $1 Billion Tax and an Incredible Investment Story.

The Partners Fund underperformed the S&P 500 by more than 40% each year during 2016 and 2017.

His fund underperformed the S&P 500 by more than 10% in 4 of the 9 years, in 2009, 2011, 2013 and 2014.

Paulson Partners Fund S & P 500
2009 6.12 26.49
2010 11.69 14.91
2011 (9.88) 1.97
2012 9.88 15.82
2013 18.39 32.18
2014 0.8 13.51
2015 (3.14) 1.25
2016 (27.23) 11.82
2017 (20.27) 21.67

How did this occur and what are the lessons for you?

Paulson’s strategy has been the opposite of many of the philosophies of WWM.

  • We believe in diversification.
  • We stress that it is difficult to outguess the markets consistently over long periods of time.
  • We do not make huge bets on single stocks or on specific industries.
  • We don’t believe in shorting stocks (betting that a stock will go down).
  • We use a consistent and replicable investment strategy.
  • All these factors worked against Paulson, since he struck it rich in 2007 and 2008.

After 2008, John Paulson and the hedge funds he manages have made huge bets, most of which have not been as successful as a broadly diversified investing strategy.

He made huge investments in gold stocks, which got crushed after 2009. In 2011, the funds lost more than $100 million on a Chinese forestry company, of which they owned 14%.

In 2014, he advocated a theme of drug industry consolidation and invested heavily in Valeant Pharmaceuticals International, Inc. The stock went higher from $140, but by April, 2016 it was under $36 per share. That month, he told his investors he would change his risk management strategy and would no longer put more than 35% of the funds assets into any one industry. It was too late however, as that strategy had contributed to years of vast underperformance. Then he invested more in Valeant and it went down much further.

The more I read about this series of events and investments, the worse it got. It is almost unbelievable that Paulson and his firm could have appeared so smart (once?) and then make so many very bad investment decisions for so many years.

Paulson’s Partners Fund lost over 10% during the first two months of 2018. Paulson Enhanced Fund, which uses borrowed money to invest in merger deals, is down 20% this year, fell 30% last year and lost about 49% in 2016. Their use of leverage amplified their incorrect bets.

It appears that he made over $1 billion in bets in 2016 and 2017 that the S&P 500 would go down. The opposite occurred, as stocks broadly rallied, and his opposite bet again was a huge loser.

The moral of this story is Paulson got very rich due to his gut instincts prior to 2007 and 2008. He is still very wealthy. He has made large donations to NYC institutions and donated $400 million to Harvard University’s School of Engineering.

However, for those who invested in his funds after 2008, which is nearly all of their outside investors, Paulson’s firm had been a disaster on a comparative basis to financial industry benchmarks.

The key for us and the clients of our firm, and for the friends or relatives of yours who do not yet use our firm: We are investing the right way…for the long term.

Others may have strategies that may work for a year or a period of time. The strategies may work temporarily.

But you are not investing for one year. You need to know and understand the strategy that your financial advisor is using for this year, and the year after that and 5 years from now. You are investing for the long-term.

If predictions and guesswork or forecasting are their strategy, or what is really underlying their actions (even if they don’t use those terms), then you are using the wrong investment strategy for your serious money.

If you are not sure what strategy your advisor or money manager is using, ask him or her. You need to find out. If you are still not sure, ask us. We can figure it out.

I’m sure that many of Paulson’s investors after 2009 would have benefited from understanding this, if they would have known how and why he was temporarily successful and been willing to understand the answers.

And now you know “the rest of the story.”

Sources:

WSJ article, Worried About Your Tax Bill?  Hedge-Fund Star John Paulson Owes $1 Billion. By Gregory Zuckerman 04/11/2018

Paulson Partner Fund data from WSJ article citied above.

S&P 500 performance information is from Vanguard 500 Index  Investor fund, VFINX, per Morningstar.com as of 4/19/18, net of fund fees.

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