RICH PICKINGS: Paulson's Midas touch

John Paulson, the famed Wall Street trader who managed to spin gold from America's sub-prime mortgage disaster, has turned his attention to the real thing. Should we believe the hype?

With gold prices soaring, investors are watching everything to do with the precious metal very closely. And there’s been plenty to watch.

In recent weeks, the Indian and Russian central banks have been bolstering their gold reserves, pushing up the gold price and putting pressure on the greenback.

This week, British bank HSBC has told its retail customers who store gold at the bank’s US vault that they need to vacate by July 2010, supposedly because big corporate clients are keen to build up their own holdings.

But perhaps the biggest news of all has been the announcement from billionaire hedge fund investor John Paulson, who will spend around $US250 million setting up a specialist gold fund that will invest in gold mining stocks and other assets related to the precious metal.

Paulson already has about 10 per cent of his $US30 billion hedge fund in gold-related investments and earlier this year bought stakes in AngloGold Ashanti and Kinross Gold. According to the gold fund’s prospectus, individual investors keen to buy into the fund will need to stump up $US10 million.

These days, Paulson’s actions and predictions are being received and dissected with a fervour usually reserved for Warren Buffett.

The reason for this is simple – Paulson, whose fortune is valued at $US6 billion, may well be the best trader in the world right now.

The fact his hedge fund has made $US20 billion in the last two years – that’s $US27.4 million a day, if you’re playing at home – certainly adds a lot of weight to the argument.

But what makes Paulson tick? And what are the secrets behind his meteoric rise?

That’s a question attacked in two recent publications, including a book called "The Greatest Trade Ever", by Wall Street Journal writer Gregory Zuckerman.

The book details how Paulson went from relatively obscure Wall Street trader to international investment superstar in a couple of years, thanks to his bet against US sub-prime mortgages.

The story of Paulson’s rise is fairly well known. Back in 2006, Paulson and a few other very smart investors became extremely concerned at the state of the US housing market; specifically the quality of the mortgages and the extraordinary jump in house prices.

He began investigating the then-new financial instruments called credit default swaps (CDSs) and, despite the fact he knew precious little about them, to use CDSs to make a huge bet against the US housing sector.

Despite some early losses when housing prices continued to soar against Paulson’s better judgement, his extraordinary bet paid off and Paulson’s fund made $US15 billion in 2007, a fair chunk of which went into his own pocket.

The next year, 2008, he slightly modified his strategy to bet against financial institutions. The result was a $US5 billion profit for his fund.

Paulson’s transformation into investor darling has also been examined in New York Magazine, in an article entitled Cranky Science.

The premise of the article, which cites Zuckerman’s book, is that the biggest factor behind Paulson’s rise is that he has become a grump.

The article argues that during Paulson’s early years, he was something of a party animal. But in the last decade, the article argues, he "remade his personality ...he lashed out at employees for overusing the printer and was so militant about healthy diets that people couldn’t eat pizza in his presence without being reprimanded.”

The article even cites research from the University of New South Wales to support the theory: "Whereas positive mood seems to promote creativity, flexibility, cooperation, and reliance on mental shortcuts, negative moods trigger more attentive, careful thinking paying greater attention to the external world.”

I’m not so sure bad moods necessarily add up to big bucks – Mr Buffett always appears to be pretty cheery – but it is worth examining the eight key strategies that Zuckerman identifies as the secrets of Paulson’s success (you can see an abridged version of his list here).

There are some obvious points, such as his willingness to go against the advice of Wall Street’s so-called experts and his scepticism about asset bubbles. But there are some real nuggets, including an excellent point about not underestimating middle-aged investors.

While Wall Street allowed its young guns to run amok during the boom years from 2005, it was actually middle-aged investors such as Paulson who made the biggest profits thanks to their experience and willingness to take a long-term view.

But Zuckerman’s best tip is: Don’t fall in love with your investments. He points out that Paulson has been able to take a very unemotional view of the market and switch from a short strategy to a long strategy very quickly. A good example of this is Paulson’s willingness to start buying financial stocks again this year after making so much betting against them in 2008.

So what’s Paulson betting on now, aside from gold?

Well he is clearly keen on banks, having bought stakes in Citigroup and Bank of America; he says the latter will double in value in 2011.

Paulson has also returned to his strategy of looking for arbitrage opportunities in mergers and has a stake in Cadbury, which remains the subject of fierce takeover speculation.

And in a vote of confidence for beleaguered media companies, Paulson also recently doubled his stake in American cable TV company Liberty Media.

Perhaps the final word on what makes Paulson such a gun investor should go to the man himself. Having hit upon the hottest of hot streaks, he clearly wants to keep going.

As he told the WSJ: "It's like Wimbledon. When you win one year, you don't quit; you want to win again."

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