Amit Shah's  Instablog

NEW YORK (Reuters) - Billionaire hedge fund manager John Paulson said on Tuesday he still sees compelling long-term returns in equities even after their sharp run-up this year, while holding no short positions in the credit markets.

"Today our net long exposure is perhaps the highest it has ever been in our portfolio," Paulson said during a luncheon presentation at the Japan Society.

"We still find a lot of compelling long investments on the equity side," he said, citing specifically Bank of America <BAC.N>, U.S. cable-television giant Comcast Corp <CMCSA.O>, and Germany's HeidelbergCement AG <HEIG.DE>.

Paulson said that at the end of 2008 he viewed the credit correction as having run its course. By April he had poured cash back into the sector.

"That is why we don't have any shorts in credit," he said.

Paulson, who has run his own hedge fund since 1994, has become a star investor after correctly predicting the sub-prime credit crisis in 2007. That reaped him a $3 billion profit.

The Standard & Poor's 500 stock index <.SPX> is up roughly 63 percent from its March nadir, but still down 30 percent from its October 2007 all-time high.

Bank of America was identified as one of Paulson's biggest positions when regulatory filings were released at the end of the second quarter of this year.

Based on his estimates of the company's earnings potential and the expectation that loan loss provisions will start to drop in 2010, Paulson remained upbeat on the beleaguered bank.

"I think the worst is behind us in terms of provisioning," Paulson said, adding: "I would expect provisioning expense to be considerably lower in 2010 versus '09 and again much lower in 2011 versus 2010."

Based on the current price at $15.47, "That seems to be a great buy today," he said.

"If we look across the markets we find a lot of great buys, whether it is HeidelbergCement or Comcast," he added.

CREDIT BUYS

Given his prescient bearish call on mortgage credits, Paulson's views are widely watched for what he has in his $33 billion investment portfolio.

He highlighted the attractive yields on credit issued by GMAC due in Sept 2011, the former General Motors automotive financing company that the U.S. government propped up at the end of 2008.

By Paulson's thinking, the government involvement is equivalent to an explicit guarantee on GMAC's finances.

"So instead of buying (a) Treasury bond which yields 84 basis points, I can buy GMAC which is almost, I consider equivalent to a government bond and I can get 11 percent. That is why we have allocated so much money to this particular security," he said.

Even as credit and equity markets looked attractive, he did reiterate his concerns that over the long-term inflation will be a problem because the government's mountain of stimulus cash will be difficult, politically, to withdraw from the economy.

"Therefore we are concerned about high rates of inflation in the future. As an investor I became very concerned about having my assets denominated in U.S. dollars," he said.

"So I looked for another currency in which to denominate my assets in. I feel that gold is the best currency."

Paulson's combined gold and gold-related investments made up more than 46 percent of his firm's holdings at the end of the second quarter of this year.

Disclosure: Long Wells Fargo, JPMorgan

Disclosure: Disclosure: Long Wells Fargo, JPMorgan

Warren Buffett loves the company, top Wall Street analysts agree that no one is giving Wells Fargo credit for the Wachovia acquisition, and Wells Fargo management continues to reiterate that they could not be happier with the integration of Wachovia. Unless you think Warren Buffet, top Wall Street analysts, Wells Fargo management, and U.S. government stress tests are all wrong, the market is clearly irrational and undervaluing this stock, in addition to undervaluing Bank of America (according to John Paulson) and JPMorgan.

I am interested in knowing what pessimists think John Paulson is missing that he is suddenly long financials, including Bank of America, Citi, JPMorgan, Suntrust, etc.

Chris Kotowski, Oppenheimer - $36 Price Target
Normalized Earnings ($s in Millions) WFC
2010E PPE 42,697
2010E Avg loans 810,900
Historic NCO/Avg loans 0.73%
Est NCOs (5,940)
Pre-tax earnings 36,757
Avg Historical Tax Rate (2001-2007) -34.05%
Taxes (12,515)
Net income 24,242
Pref dividends + Other (1,199)
Shares (M) 4,891
"New" Normalized EPS $4.71
"Old" Normalized EPS $4.61

Normalized EPS $4.71
x Average Historic P/E Multiple 12
= Implied Value Using Normalized EPS $56.53

Goldman Sachs - $35 Price Target
Upgrade Wells Fargo to Buy: Wells is the big winner this cycle on change in tangible assets per share, up 70% from 2Q07 to 2Q09. The reason is simple: Wells bought Wachovia at a depressed price. Up until now, leverage has held us back as Wells has among the lowest capital ratios in the industry and still needs to repay TARP. That said, we estimate that tangible common equity could increase 70bp to 4.3% this quarter via a) earnings and realization of deferred tax asset (+30bp), and b) improvement in securities prices (+40bp). Capital will still be lower than peers but will be in better shape, and the dilution concern overhang should moderate.

Vivek Juneja, JPMorgan - $36.50 Price Target
Our price target for Wells Fargo of $36.50 by year end 2010 assumes 2.8x tangible book value multiple for WFC and peer group multiple of 1.75x tangible book value. We continue to expect WFC to trade at a considerable premium to the group because of its strong long term track record.

Betsy Graseck, Morgan Stanley - $44 Price Target
We are Overweight WFC in the context of an Attractive view on the large cap banks. Our Overweight rating is driven by high expected accretion in 2010-2011 from the WB acquisition, due to our forecast for $7 bil in cost saves (above management’s $5 bil estimate). We believe loss estimates for WFC’s core loan book are known by the Street and reflected in the current stock price.

Disclosure: Long Wells Fargo

Simple Investment Thesis: pre-provision pre-tax earnings and normalized earnings power has NEVER been higher, banks are not paying dividends so tangible book value is increasing rapidly, and capital ratios are higher than ever in an improving economic environment. Wells Fargo stock price is the same as pre-Wachovia despite a huge increase in earning assets relative to the increase in shares outstanding, a fortress like balance sheet with an incredible financing mix (the lowest cost of capital and cheapest deposit base of all large-cap US banks). In the next few months, the large-cap U.S. banks will go much higher. If you listen to the bears, you will miss the rally (John Paulson and Warren Buffett are far more intelligent than Meredith Whitney, and Dick Bove said to buy Wells Fargo last year when its earnings power was lower, capital ratios were worse, and tangible book value was lower, and its stock price was higher). Anyone investing based on Meredith Whitney and Dick Bove's advice will miss the next leg higher on large-cap banks. Also, Dick Bove should explain why Bank of America and Citi are better buys than Wells Fargo, which has a far superior management team, the best deposit base in the industry, and more consistent earnings power. If he thinks Wells Fargo needs more capital, then Bank of America DEFINITELY needs more capital. Personally, I think all the banks capital ratios are much healthier than in any time in the last five years and I would be strong buyer of Wells Fargo, JPMorgan, and Bank of America.

Two of the world's best investors continue to be extremely positive on the large-cap financial institutions -

John Paulson's most recent quarterly letter on November 16, 2009 explains return analysis for Bank of America:

Bank of America
Pre-Credit Pre-Tax Income (2011) = $57,500 million
Normalized Provision (1.75% of Loans) = (16,357) million
Preferred Dividend & Income Tax = (14,963) million
Net Income (for common shares) = 26,132 million
Fully Diluted Shares = 8,802 million
Normalized EPS = $2.97
Multiple = 10.0x
Value at 12/31/2011 = 29.81
Current Price (as of 9/30/09) = $16.92
Annual Return = 34%
Multiple of Investments = 1.8x

Paulson forecasts the current write-down cycle will end December 31, 2011, and visibility for growth will resume in 2012.

Warren Buffett added to his Wells Fargo holdings by over 10 million shares in the most recent quarter ended 9/30/2009. John Stumpf, CEO and President of Wells Fargo, made some extremely positive comments on the company this past week -

Commercial Real Estate
Nearly $500 billion in commercial real estate loans will mature in each of the next few years.

“One reason you’re seeing less pain is because interest rates are so low,” Stumpf said. “The carrying costs of these properties are at record low levels. That being said, you can’t carry it forever if there’s no cash flow on these properties.”

“On the Wells side, while like other banks, ours has taken bumps, but I think it’s the finest underwritten commercial loan portfolio in the country,” he said. “On the Wachovia side there was more risk in the portfolio, but at the time of the merger we wrote that down, we took big substantial hits on that portfolio. So in many cases our losses are already behind us.”

Loans
“We’ve got our team marching double time looking for loans,” Stumpf said. “You hear from time to time that banks aren’t lending money, we’re lending all the money we can.”

Industry wide, loan demand is down as businesses retrench. Since the start of the credit crunch, some in business and in government have complained about the lack of bank liquidity, but bankers have generally been quick to counter that they are making loans to creditworthy borrowers, though standards have tightened.

“As an industry I think one of the biggest challenges will be not enough earning assets, not enough loans,” he said.

Stumpf said the banks are one-third of the way into their three-year integration process. Wells Fargo expected $60 billion in losses over those three years as it came to grips with soured loans within the combined Wells Fargo-Wachovia portfolio. Much of that, about $41 billion, was realized in the first year, as planned.

“We’re still in same zip code with those numbers,” he said, adding that synergies from merged operations are being realized a faster clip than originally planned, and losses from legacy Wachovia’s risky option-arm Pick & Pay mortgage portfolio are actually not as steep as originally feared, despite deepening financial gloom.

“We’re on track, we’re on schedule and we’re under budget,” Stumpf said. "I couldn’t be happier, I couldn’t be more excited.”

The bank’s mortgage origination business, he said, “is booming.” The company originates about one in four U.S. mortgages and services one in six.

Georgia is one of the nation’s leading centers of the foreclosure crisis, but Stumpf said the state has fared better than many areas, including Florida.

“On residential side, seeing signs, especially on the lower end, we’ve reached the bottom,” he said.

The bank has seen home prices rebound from the bottom in California, but losses are continuing in regions like the Sunshine State.

Wachovia and Wells Fargo have modified 400,000 home loans and refinanced 1.1 million loans Stumpf said. Overall, the mortgages on its balance sheet, he said, “have held up exceedingly well.”

Conclusion
JPMorgan, Wells Fargo, and Bank of America are the leading commercial banks in America as we emerge out of the financial and economic crisis of the past 24 - 30 months. Their stock prices today reflect current earnings power and not normalized earnings, which John Paulson says will emerge in the back half of 2011. With extremely low short-term interest rates (3-month treasury yields at .01%, 6-month yields at .13%, and 12-month yields at .26%), the steep yield curve makes banking in an incredibly profitable business today.

Disclosure: Long Wells Fargo, JPMorgan, Bank of America