Getting Mugged by Mr. Market

 | Jan 10, 2012 | 2:00 PM EST
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One of the more interesting, and potentially profitable, exercises is to examine the portfolios of those who have been successful in the past but are struggling or losing money recently.

I'm not interested in gloating, as so many do when others stumble and fall. I just want to examine the portfolio and ask if a person who has been smart for a long time has suddenly gotten stupid, or just gotten mugged by Mr. Market. This happens to us all from time to time, and I have seen even the most brilliant people on the planet crushed by poor timing and too much leverage. When it happens, I find that the portfolios of the fallen often contain stocks that are now ready to perform as originally anticipated.

In today's world of millisecond money management, I also want to look for signs of forced selling. When the mighty fall, they are often subject not just to margin calls, but investor redemptions. In a "What have you done for me lately?" world, investors lose patience and want to withdraw their cash when returns diminish. We saw forced selling in late 2008, and buying what others were forced to get rid of turned out to be very profitably for those with available cash. Being the buyer of last resort is often one the more profitable activities you will ever engage in as an investor.

The best example if a stumbling fund this year is Paulson & Co. After making a fortune betting against subprime, John Paulson has seen his fund's value drop nearly sevenfold in 2011. Paulson's large leveraged bets on financials didn't work out as he had anticipated. Did he lose his touch, or was he just too early? When I look at his largest holdings, the bet to make is that he was just really early and his stock picks and hedge fund will recover strongly in 2102 and beyond.

Paulson has large bets on Citigroup (C), Bank of America (BAC) and other large-cap financial stocks. In all, about a fourth of his holdings were in financial stocks at the end of the third quarter. I am not a fan of these banks that were at the center of the credit crisis, but if I am intellectually honest, as much as I dislike Bank of America as an institution, its financial profile is not that much different from Royal Bank of Scotland's (RBS), a bank stock that I own. BAC needs to sell some assets and probably find additional sources of capital in 2012, but odds are it survives and eventually trades a lot higher than 30% of book value. The stock has recovered nicely from the November lows, but it could see more selling when BAC releases fourth-quarter earnings. If it pulls back near the lows, it is worth buying for aggressive investors.

The funds' other bank stocks are decent banks. I have no problems with Capital One (COF), Wells Fargo (WFC) or SunTrust (STI). They have all had their share of problems during the banking and credit crisis, but all are survivors and should trade at higher multiples of book value and earnings in the next few years.

My preference is for smaller banks, but I if I was running a multibillion-dollar fund, I would be looking at stocks like many of Paulson's large holdings. The funds also had sizable stakes in two banks that might be considered stressed or even distressed. Both Popular (BPOP) and Regions Financial (RF) could stage strong recoveries, resulting in rather large profits for Paulson's fund. I am familiar with both and I believe they are reasonable speculations.

Paulson's funds were also early in buying into hotel real estate investment trusts. I feel his pain, as I have been right there with him in many of the stocks he owns. Hotels are the most undervalued class of commercial real estate and offer incredible potential over the next decade. The economy will eventually gain traction and when it does, business and recreational travel will drive asset pricing in the hotel market. Hotel REITs such as Sunstone Hotel Investors (SHO), FelCor Lodging Trust (FCH) and Ashford Hospitality Trust (AHT) should offer investors outsized returns, as hotels again trade at a multiple of asset value instead of the current fraction.

I doubt that John Paulson has lost his touch. In fact, his distressed and arbitrage funds all delivered solid returns in 2012. It looks to me like one of those muggings by Mr. Market that happen to all of us at one time or another. If I'm right, then the stocks in Paulson's equity portfolio are probably going to be a great source of profitable investment ideas this year.



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