Could 2012 Be A Bright Year For John Paulson?

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 |  Includes: APC, DLPH, ESRX, GLD, GR, HIG, KMI, MHS, UTX
by: Insider Monkey

John Paulson is not a great stock picker - there, we said it. Instead, he is more of a macro-themed kinda guy, or at least he is now. When Paulson founded his firm, he was using a merger arbitrage strategy - after all, that was what he was experienced in - but that strategy became overcrowded as more and more hedge funds sprung up. A few years ago, Paulson tried a different strategy and it paid off hugely. He doesn't pick a single stock in a sector but rather invests in clusters, picking several stocks from each sector in which he invests.

The year was 2007. Paulson's hedge fund made 51.74% versus 5.61% for the S&P 500, thanks largely to bets against subprime mortgages. The next year, the fund returned 6.28% while the S&P 500 lost roughly 37%.

Since then, things have gone downhill. Paulson & Co. reported returns of 6.12% in 2009. The market returned 26.5%. In 2010, Paulson started to narrow the gap but fell short. Paulson's Advantege fund made 11.68% while the S&P 500 brought in 15.1%.

However, the trend did not continue. Paulson & Co. was one of the worst performing hedge funds of 2011. The problem was a combination of keeping huge positions in stocks that just didn't bounce back as quickly as expected, like financials, and poor timing. Paulson, shocked by major losses, significantly reduced his exposure, but he reacted too quickly, missing out on a rally that could have saved his numbers. Instead, Paulson & Co.'s Advantage Plus fund finished the year down 52.64% while its Advantage fund dropped 35.96%. Paulson's Recovery fund was down 27.73%, its Credit Opportunities fund fell 18.24%, its gold fund dipped 10.5% and the Paulson Partners dropped 10%. So, definitely not the red letter year Paulson and his investors no doubt hoped for, or at least the right type of red letter.

But 2012 is a new year. According to a 13F filed February 14, Paulson & Co. had a portfolio of 84 positions worth roughly $13.88 billion, down from a value of $20.69 billion at the end of the third quarter. While Paulson may be off to a "low" start, he certainly isn't off to a "slow" start. Through January 2012, Paulson returned roughly 5% and that may just be the beginning.

Looking just at Paulson & Co.'s largest positions at the end of the fourth quarter, there are plenty of reasons to be enthusiastic about what the future holds for the firm. Year-to-date (through the close of trading on February 17), the S&P 500 has returned just about 7%. Several of Paulson's top positions have returned more than that.

Paulson's largest position at the end of the fourth quarter was the SPDR Gold Trust (NYSEARCA:GLD). He had 17.31 million shares in the holding, valued at $2.63 billion at the end of December. Year to date, that stock has returned 7.33%. Paulson's third largest position, Delphi Auto Plc (NYSE:DLPH), was made up of 51.73 million shares valued at $1.11 billion at the end of the fourth quarter. Delphi has returned a whopping 40.69% year-to-date.

Anadarko Petroleum Corp (NYSE:APC), Paulson's fourth largest position at the end of the fourth quarter with a value of $731.21 million or 9.58 million shares, is up 11.95% so far this year. Hartford Financial (NYSE:HIG) was the fifth largest position in Paulson's portfolio at the end of December. The fund closed the fourth quarter with 37.45 million shares of the stock, valued at $608.56 million. It has returned 28.79% year-to-date. With numbers like these, 2012 may be a very bright year for John Paulson indeed.

The other positions in Paulson's portfolio that attracted our attention was Goodrich (NYSE:GR), Medco Health Solutions (NYSE:MHS) and El Paso (EP). These are merger arbitrage plays which Paulson thinks are likely to go through. If Paulson is right investors can make 11.1% in four months by betting on the MHS and Express Scripts (NASDAQ:ESRX) merger. The El Paso - Kinder Morgan (NYSE:KMI) merger is expected to deliver 8.7% in four months. The Goodrich and United Technologies (NYSE:UTX) merger is expected to deliver only 1.3% in four months.

Our favorite pick in this case is Medco Health Solutions because it is a stock that we wouldn't mind holding even if the deal falls apart. The stock is inexpensive with a forward PE ratio of 14 and is expected to grow its earnings by 13% annually over the next five years. We think it can surprise to the upside. We should note that betting on these mergers isn't riskless and you should do your due diligence before making any decisions.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.