Billionaire John Paulson's hedge-fund firm, Paulson & Co, filed its most recent 13F (institutional managers who manage over $100 million are required to report their long positions in the U.S. markets each quarter) for the quarter ended June 30, and he's making a huge bet on financials...

 

Paulson gained fame in 2007 after he made over $3 billion shorting subprime securities. He then added to his financial short by selling shares of British banking giants Lloyds TSB Group, HBOS, Barclays, and Royal Bank of Scotland. All four plunged, and Paulson made even more.

 

Next he made a huge bet on inflation, piling almost $5 billion (around 16% of his fund) into gold and gold stocks (Paulson is the largest shareholder of the $34 billion SPDR Gold ETF).

 

Obviously not one for conservative position sizing, Paulson has now plowed into financial stocks. His firm bought 167 million shares of Bank of America, 7 million shares of JPMorgan, 2 million Goldman shares, 35 million shares of Regions Financial, 17 million shares of Capital One, and massive positions in six other financial firms. And he's probably already made billions on his new positions considering the market rally since March – Bank of America, his largest new position, is up around 40% from where he bought it.

 

From a reader: I have purchased many of your [True Income] recommendations at deep discounts late last year. I feel your letter alone is worth my Alliance membership. But I also engage in higher risk plays and was considering the Tribune bond. At less than 10 cents on the dollar, the risk to reward looks interesting. It seems that zero gain and/or a delayed payoff date would be about the worst-case outcome. Any comments?

 

The investment strategy you propose is a valid one. It takes a special set of skills to do this successfully. First, you need to be very practiced and fluent in the bankruptcy process and its opportunities and risks. You also need to have excellent credit skills to analyze the value of a company's assets and their liquidation value. You need to be knowledgeable in the ways of corporate behavior, which are often not motivated by what's in the best interest of the shareholder. And finally, you need to be familiar with bond trading. The worst outcome is much worse than you suggest...

 

The worst outcome is a total loss of your capital after committing it for several years. This is a high-risk, high-return strategy requiring special skills and a long-term investment horizon. There are investors who succeed in this strategy. But they possess this special skill set and are willing to make the huge time commitment necessary and commit a significant part of their portfolio to this strategy. They also take a portfolio approach, which means they buy a collection of bankrupt bonds so they spread their risk.

 

We just published the new issue of True Income. Editor Mike Williams' latest recommendation is a bond that will pay you 9% in cash and earn you 16.2% a year for the next four years. It also has a convertible aspect, meaning you have unlimited upside potential in the common stock. Click here to learn more.

 

"Maybe what we should have done was not bought it," said Steve Feinberg, co-founder of hedge fund Cerberus Capital Management, in regard to his firm's ill-fated 2007, $7 billion purchase of Chrysler. Longtime readers will recall my sarcastic quarterly letters from the "chairman" of General Motors from exactly the same period. Using the satiric voice of the "chairman," I explained a serious fact: GM couldn't afford the $5 billion in interest it owed on its debts each year. And as its credit rating fell, its interest expenses would rise, resulting, inevitably, in a bankruptcy filing.

 

Although you had to be able to read financial statements to determine these facts, it didn't take much more than common sense to realize a company that hadn't earned enough money to pay the interest on its debts since 1992 and had added to its debt pile in 19 of the last 20 years probably wasn't going to make it. Here's the incredible part: Chrysler's debt load was even larger. It would have to earn $10 billion a year, just to pay the interest on its obligations.

 

With the Cerberus-Chrysler story in the back of your mind... allow me to share two secrets I know to be true about hedge funds. First, they are all destined to fail. And second, the entire industry consumes capital. Thus, while you might make money on a given fund, in total, hedge-fund investors are destined to lose money.

 

Why? Hedge funds are doomed by the Peter Principle. The Peter Principle, you'll recall, is that in the corporate world people tend to be promoted to the point of incompetence. Someone who is a really good salesman isn't necessarily a good manager. Someone who is a good manager isn't necessarily a good corporate executive. And someone who is a good corporate executive isn't necessarily a good CEO. But nobody knows where they'll top out in ability before it's too late. The same thing is true with hedge funds – with catastrophic financial consequences.

 

In the case of Cerberus, Steve Feinberg was a great distressed (junk) bond investor. Michael Milken trained him. He has an unbelievably high I.Q. and beat almost anyone in chess – blindfolded. This gave him a valuable edge in the debt market and attracted a large and powerful group of investors. They promoted Feinberg, in terms of capital and influence, into the top rung of the hedge-fund world – where he failed miserably. He reached his Peter level. And his investors lost $6 billion last year. While I don't know it for a fact, my guess is that's more money than Cerberus earned, in total, to date.

 

Here's how it happens: These fund managers pile their gains up and reinvest their capital in their next big trade. But... sooner or later they reach a level of capital under management that requires them to move into new areas. And eventually, they blow up. I know of only one hedge-fund manager who cashed out of his entire fund near the top in 2007. Only one.

 

Regards,

 

Porter Stansberry