FA Alpha Daily

This Fund Made a Killing During the Great Recession. Here’s What It Thinks About the Housing Market Today

Banks and investors gave the housing market far too much leverage, and it swiftly reached its peak before collapsing. Some smart investors, like John Paulson of Paulson & Co., anticipated this event and were able to earn millions or even billions. From Paulson’s point of view, home prices are due for a major drop. However, the other side of the equation appears much better since the economy is in strong enough health to withstand a downturn. In today’s FA Alpha, we’ll examine Paulson & Co.’s portfolio through the perspective of Uniform Accounting in order to see how this strategy may benefit the company.

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The last true economic cycle recession, as opposed to a fluke pandemic, was the Great Recession of 2008.

Banks and investors added far too much leverage to the housing market, which quickly reached a head before crumbling down.

Some shrewd investors figured out this was coming and were able to make millions, if not billions, on some trades.

One of the most famous and successful was John Paulson of Paulson & Co.

In 2005, his firm saw just how much excess leverage was on the housing market, and had modeled out that it was due to burst at some point.

The bubble continued to grow in 2005 and 2006, but 2007 was an exceptional year for Paulson.

As bonds began to default in 2007, Paulson earned over a 100% return on his strategy and made $15 billion in that year alone.

Since then, Paulson & Co. has been a valuable source for understanding the housing market. Some have started to discuss the current housing market in a similar vein as in 2007, but Paulson has a different take.

The way Paulson sees it now, home prices are due for a major correction. With folks seeking more space and moving out of cities, the housing market became as hot as it had been since the Great Recession.

While that sounds alarming, the other side of the equation is looking much healthier. In other words, the financial system is healthy enough to handle a downturn.

So this time around, Paulson & Co. might not be piling on the housing trade, but the fund isn’t sitting still.

Let’s see Paulson & Co’s portfolio through the Uniform Accounting lens and see how this strategy could play out for him.

Economic productivity is massively misunderstood on Wall Street. This is reflected by the 130+ distortions in the Generally Accepted Accounting Principles (GAAP) that make as-reported results poor representations of real economic productivity.

These distortions include the poor capitalization of R&D, the use of goodwill and intangibles to inflate a company’s asset base, a poor understanding of one-off expense line items, as well as flawed acquisition accounting.

It’s no surprise that once many of these distortions are accounted for, it becomes apparent which companies are in real robust profitability and which may not be as strong of an investment.

See for yourself below.

Using as-reported accounting, investors would think investing in a highly successful opportunist is not really rewarding at all.

On an as-reported basis, many of these companies are weak performers in terms of profitability and operate with an average as-reported ROA of 5%, which is below the U.S. corporate average of 12%, and below cost of capital levels around 6%.

Once we make Uniform Accounting adjustments to accurately calculate earning power, we can see that most companies in Paulson’s portfolio are stronger than you might realize.

Once the distortions from as-reported accounting are removed, we see that Horizon Therapeutics Public Limited Company (HZNP) doesn’t have 5% returns. It actually has a 65% Uniform ROA.

Similarly, VMware’s (VMW) Uniform ROA is 98%, not the 5% figure as-reported metrics would suggest.

To find companies that can deliver alpha beyond the market, just finding companies where as-reported metrics misrepresent a company’s real profitability is insufficient.

To really generate alpha, any investor also needs to identify where the market is significantly undervaluing the company’s potential.

These dislocations demonstrate that most of these firms are in a different financial position than GAAP may make their books appear. But there is another crucial step in the search for alpha. Investors need to also find companies that are performing better than their valuations imply.

Valens has built a systematic process called Embedded Expectations Analysis to help investors get a sense of the future performance already baked into a company’s current stock price. Take a look:

This chart shows four interesting data points:

  • The average Uniform ROA among Paulson’s top 15 holdings is actually 27%. That’s more than twice the corporate average.
  • The analyst-expected Uniform ROA represents what ROA is forecasted to do over the next two years. To get the ROA value, we take consensus Wall Street estimates and convert them to the Uniform Accounting framework.
  • The market-implied Uniform ROA is what the market thinks Uniform ROA is going to be in the three years following the analyst expectations, which for most companies here are 2023, 2024, and 2025. Here, we show the sort of economic productivity a company needs to achieve to justify its current stock price.
  • The Uniform P/E is our measure of how expensive a company is relative to its Uniform earnings. For reference, the average Uniform P/E across the investing universe is roughly 20x.

Embedded Expectations Analysis of Paulson & Co paints a clear picture. Over the next few years, Wall Street analysts expect the companies in Paulson’s portfolio to slightly contract in profitability, but the market expects a bigger decline.

Analysts forecast the portfolio holdings on average to see Uniform ROA rise to 51% over the next two years, while the market is pricing to see returns expand even further to 66%. In other words, the market is already pricing in substantial profitability growth.

For example, International Tower Hill Mines (TSX: ITH) currently loses 11% per year. Analysts think this is reasonable. Over the next two years, Wall Street analysts project Uniform ROA to stay negative. However, the market is pricing the company to reach 24% Uniform ROA, meaning investors may end up disappointed.

Occidental (OXY) is a good example of the energy world. Its Uniform ROA was just 3% last year when oil and gas prices were still low and activity was low. This year though, analysts expect Uniform ROA to skyrocket to 88%. The market already seems to be pricing this in though – with the market implied Uniform ROA sitting at 90%.

Overall, the portfolio is composed of high-quality names which are known for their historical success and names that can deliver impressive returns on investments. However, before making any investment decision, investors should be careful about the valuation and analyze them accordingly.

This just goes to show the importance of valuation in the investing process. Finding a company with strong profitability and growth is only half of the process. The other, just as important part, is attaching reasonable valuations to the companies and understanding which have upside which has not been fully priced into their current prices.

To see a list of companies that have great performance and stability also at attractive valuations, the Valens Conviction Long Idea List is the place to look. The conviction list is powered by the Valens database, which offers access to full Uniform Accounting metrics for thousands of companies.

Click here to get access.

Read on to see a detailed tearsheet of one of Paulson & Co’s largest holdings.

SUMMARY and Horizon Therapeutics Public Limited Company Tearsheet

As one of Paulson & Co. Inc.’s largest individual stock holdings, we’re highlighting Horizon Therapeutics Public Limited Company (HZNP:USA) tearsheet today.

As the Uniform Accounting tearsheet for Horizon Therapeutics Public Limited Company highlights, its Uniform P/E trades at 12.7x, which is above the global corporate average of 18.9x, but around its historical average of 12.2x.

Low P/Es require low EPS growth to sustain them. That said, in the case of Horizon Therapeutics Public Limited Company, the company has recently shown 64% Uniform EPS growth.

Wall Street analysts provide stock and valuation recommendations that, in general, provide very poor guidance or insight. However, Wall Street analysts’ near-term earnings forecasts tend to have relevant information.

We take Wall Street forecasts for GAAP earnings and convert them to Uniform earnings forecasts. When we do this, Horizon Therapeutics Public Limited Company’s Wall Street analyst-driven forecast is for EPS to shrink by 15% and grow 35% in 2022 and 2023, respectively.

Furthermore, the company’s return on assets was 45% in 2021, which is above the long-run corporate averages. Also, cash flows and cash on hand consistently exceed its total obligations—including debt maturities and CAPEX maintenance. Moreover, its intrinsic credit risk is 60bps above the risk-free rate. Together, these signal low credit risks.

Lastly, Horizon Therapeutics Public Limited Company’s Uniform earnings growth is in line with peer averages, and peer valuations.

Best regards,

Joel Litman & Rob Spivey

Chief Investment Strategist &
Director of Research
at Valens Research

This portfolio analysis highlights the same insights we share with our FA Alpha Members. To find out more, visit our website.

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